THE PARTIAL

EQUILIBRIUM
COMPETITIVE MODEL

Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. 1

Market Demand

• Assume that there are only two goods (x and y)

• An individual’s demand for x is
Quantity of x demanded = x(px,py,I)
• If we use i to reflect each individual in the market, then the
market demand curve is

n
Market demand for X = å x i ( px , py , Ii )
i =1

2
Market Demand

• To construct the market demand curve, PX is allowed to

vary while Py and the income of each individual are held
constant.
• If each individual’s demand for x is downward sloping, the
market demand curve will also be downward sloping.

3
Market Demand
To derive the market demand curve, we sum the
quantities demanded at every price

px px px
Individual 1’s Individual 2’s Market demand
demand curve demand curve curve

px*

x1 x2 X

x1* x x2* x X* x

x1* + x2* = X*

4
Shifts in the Market Demand Curve

• The market demand summarizes the ceteris paribus

relationship between X and px
• changes in px result in movements along the curve (change in
quantity demanded)
• changes in other determinants of the demand for X cause the
demand curve to shift to a new position (change in demand)

5
Shifts in Market Demand

• Suppose that individual 1’s demand for oranges is given by

x1 = 10 – 2px + 0.1I1 + 0.5py
and individual 2’s demand is
x2 = 17 – px + 0.05I2 + 0.5py
• The market demand curve is
X = x1 + x2 = 27 – 3px + 0.1I1 + 0.05I2 + py

6
Shifts in Market Demand

• To graph the demand curve, we must assume values for

py, I1, and I2

• If py = 4, I1 = 40, and I2 = 20, the market demand curve

becomes
X = 27 – 3px + 4 + 1 + 4 = 36 – 3px

7
Shifts in Market Demand

• If py rises to 6, the market demand curve shifts outward to

X = 27 – 3px + 4 + 1 + 6 = 38 – 3px
• note that X and Y are substitutes
• If I1 fell to 30 while I2 rose to 30, the market demand would shift
inward to
X = 27 – 3px + 3 + 1.5 + 4 = 35.5 – 3px
• note that X is a normal good for both buyers

8
Generalizations

• Suppose that there are n goods (xi, i = 1,n) with prices pi, i =
1,n.
• Assume that there are m individuals in the economy
• The j th’s demand for the i th good will depend on all prices
and on Ij
xij = xij(p1,…,pn, Ij)

9
Generalizations

• The market demand function for xi is the sum of each

individual’s demand for that good

m
X i = å x ij ( p1,..., pn , I j )
j =1

• The market demand function depends on the prices

of all goods and the incomes and preferences of all
buyers
10
Elasticity of Market Demand

• The price elasticity of market demand is measured by

¶QD (P, P ' , I ) P

eQ,P = ×
¶P QD
• Market demand is characterized by whether demand is elastic (eQ,P <-
1) or inelastic (0> eQ,P > -1)

11
Elasticity of Market Demand

• The cross-price elasticity of market demand is

measured by

¶QD (P, P ' , I ) P '

eQ,P = ×
¶P ' QD
• The income elasticity of market demand is measured
by
¶QD (P, P ' , I ) I
eQ,I = ×
¶I QD
12
 Timing of the Supply Response
• In the analysis of competitive pricing, the time period under
consideration is important
• very short run
• no supply response (quantity supplied is fixed)
• short run
• existing firms can alter their quantity supplied, but no new firms can enter the
industry
• long run
• new firms may enter an industry

13
Pricing in the Very Short Run

• In the very short run (or the market period), there is no

supply response to changing market conditions
• price acts only as a device to ration demand
• price will adjust to clear the market
• the supply curve is a vertical line

14
Pricing in the Very Short Run
When quantity is fixed in the
Price very short run, price will rise
S from P1 to P2 when the demand
rises from D to D’

P2

P1
D’

Quantity
Q*

15
Short-Run Price Determination

• The number of firms in an industry is fixed

• These firms are able to adjust the quantity they are
producing
• they can do this by altering the levels of the variable inputs they
employ

16
Perfect Competition
• A perfectly competitive industry is one that obeys the following
assumptions:
• there are a large number of firms, each producing the same homogeneous product
• each firm attempts to maximize profits
• each firm is a price taker
• its actions have no effect on the market price
• information is perfect
• transactions are costless

17
Short-Run Market Supply

• The quantity of output supplied to the entire market in the

short run is the sum of the quantities supplied by each firm
• the amount supplied by each firm depends on price
• The short-run market supply curve will be upward-sloping
because each firm’s short-run supply curve has a positive
slope

18
Short-Run Market Supply Curve
To derive the market supply curve, we sum the quantities
supplied at every price

Firm A’s
P supply curve P P
sB
sA Market supply S
Firm B’s
supply curve curve

P1

q1A quantity q1B quantity Q1 Quantity

q1A + q1B = Q1

19
Short-Run Market Supply Function

• The short-run market supply function shows

total quantity supplied by each firm to a
market
n
Qs (P,v ,w ) = å qi (P,v ,w )
i =1

• Firms are assumed to face the same

market price and the same prices for
inputs
20
Short-Run Supply Elasticity
• The short-run supply elasticity describes the
responsiveness of quantity supplied to changes in
market price

% change in Q supplied ¶QS P

eS,P = = ×
% change in P ¶P QS

• Because price and quantity supplied are positively

related, eS,P > 0

21
A Short-Run Supply Function

• Suppose that there are 100 identical firms each with the
following short-run supply curve
qi (P,v,w) = 10P/3 (i = 1,2,…,100)
• This means that the market supply function is given by

100 100
10P 1000P
Qs = å qi = å =
i =1 i =1 3 3

22
A Short-Run Supply Function
• In this case, computation of the elasticity of supply
shows that it is unit elastic

¶QS (P,v ,w ) P 1000 P

eS,P = × = × =1
¶P QS 3 1000P / 3

23
Equilibrium Price Determination
• An equilibrium price is one at which quantity demanded is
equal to quantity supplied
• neither suppliers nor demanders have an incentive to alter their
economic decisions
• An equilibrium price (P*) solves the equation:

QD (P *, P ' , I ) = QS (P *,v ,w )

24
Equilibrium Price Determination
• The equilibrium price depends on many exogenous
factors
• changes in any of these factors will likely result in a new
equilibrium price

25
Equilibrium Price Determination

The interaction between

Price market demand and market
S
supply determines the
equilibrium price

P1

Q1 Quantity
26
Market Reaction to a Shift in Demand

If many buyers experience

an increase in their demands,
the market demand curve
will shift to the right

27
Market Reaction to a Shift in Supply

If the market price rises, firms

Price will increase their level of
SMC output

SAC
This is the short-run
P2
supply response to an
P1 increase in market price

q1 q2 Quantity
28
Shifts in Supply and Demand Curves
• Demand curves shift because
• incomes change
• prices of substitutes or complements change
• preferences change
• Supply curves shift because
• input prices change
• technology changes
• number of producers change

29
Shifts in Supply and Demand
Curves
• When either a supply curve or a demand curve shift,
equilibrium price and quantity will change
• The relative magnitudes of these changes depends on the
shapes of the supply and demand curves

30
Shifts in Supply
Shifts in Demand
Changing Short-Run Equilibria
• Suppose that the market demand for luxury beach towels is
QD = 10,000 – 500P
and the short-run market supply is
QS = 1,000P/3
• Setting these equal, we find
P* = $12
Q* = 4,000

33
Changing Short-Run Equilibria
• Suppose instead that the demand for luxury towels rises to
QD = 12,500 – 500P
• Solving for the new equilibrium, we find
P* = $15
Q* = 5,000
• Equilibrium price and quantity both rise

34
Changing Short-Run Equilibria
• Suppose that the wage of towel cutters rises so that the
short-run market supply becomes
QS = 800P/3
• Solving for the new equilibrium, we find
P* = $13.04
Q* = 3,480
• Equilibrium price rises and quantity falls

35
Mathematical Model of Supply and Demand
• Suppose that the demand function is represented by
QD = D(P,a)
• a is a parameter that shifts the demand curve
• ¶D/¶a = Da can have any sign
• ¶D/¶P = DP < 0

36
Mathematical Model of Supply and
Demand
• The supply relationship can be shown as
QS = S(P,b)
• b is a parameter that shifts the supply curve
• ¶S/¶b = Sb can have any sign

• ¶S/¶P = SP > 0

• Equilibrium requires that QD = QS

37
Mathematical Model of Supply and Demand
• To analyze the comparative statics of this model, we need to use the
total differentials of the supply and demand functions.
• Suppose that the demand parameter (a) changed while b remains
constant

dQD = DPdP + Dada

dQS = SPdP + Sbdb

• Maintenance of equilibrium requires that

38
39
Mathematical Model of Supply and
Demand
Hence we can solve for the change in equilibrium price as

40
Mathematical Model of Supply and Demand
• We can convert our analysis to elasticities
¶P a Da a
eP ,a = × = ×
¶a P SP - DP P
a
Da
Q eQ,a
eP ,a = =
P eS,P - eQ,P
(SP - DP ) ×
Q

41
Long-Run Analysis
• In the long run, a firm may adapt all of its inputs to fit market
conditions
• profit-maximization for a price-taking firm implies that price is equal
to long-run MC
• Firms can also enter and exit an industry in the long run
• perfect competition assumes that there are no special costs of
entering or exiting an industry

42
Long-Run Analysis

• New firms will be lured into any market for which economic
profits are greater than zero
• entry of firms will cause the short-run industry supply curve to shift
outward
• market price and profits will fall
• the process will continue until economic profits are zero

43
Long-Run Analysis

• Existing firms will leave any industry for which economic

profits are negative
• exit of firms will cause the short-run industry supply curve to shift
inward
• market price will rise and losses will fall
• the process will continue until economic profits are zero

44
Long-Run Competitive Equilibrium

• A perfectly competitive industry is in long-run equilibrium if

there are no incentives for profit-maximizing firms to enter or
to leave the industry
• this will occur when the number of firms is such that P = MC = AC
and each firm operates at minimum AC

45
Long-Run Competitive Equilibrium

• We will assume that all firms in an industry have identical

cost curves
• no firm controls any special resources or technology
• The equilibrium long-run position requires that each firm
earn zero economic profit

46
Long-Run Equilibrium: Constant-Cost Case

• Assume that the entry of new firms in an industry has no effect

on the cost of inputs
• no matter how many firms enter or leave an industry, a firm’s cost
curves will remain unchanged
• This is referred to as a constant-cost industry

47
Long-Run Equilibrium: Constant-Cost Case
Long-Run Equilibrium: Constant-Cost Case
Long-Run Equilibrium: Constant-Cost Case
Long-Run Equilibrium: Constant-Cost Case
Long-Run Equilibrium: Constant-Cost Case
Infinitely Elastic Long-Run Supply

• Suppose that the total cost curve for a

typical firm in the bicycle industry is
TC = q3 – 20q2 + 100q + 8,000

• Demand for bicycles is given by

QD = 2,500 – 3P

53
Infinitely Elastic Long-Run Supply

• To find the long-run equilibrium for this market, we must find

the low point on the typical firm’s average cost curve
• where AC = MC
AC = q2 – 20q + 100 + 8,000/q
MC = 3q2 – 40q + 100
• this occurs where q = 20
• If q = 20, AC = MC = $500
• this will be the long-run equilibrium price

54
Shape of the Long-Run Supply Curve
• The zero-profit condition is the factor that determines the
shape of the long-run cost curve
• if average costs are constant as firms enter, long-run supply will be
horizontal
• if average costs rise as firms enter, long-run supply will have an
upward slope
• if average costs fall as firms enter, long-run supply will be
negatively sloped

55
Long-Run Equilibrium: Increasing-Cost Industry
• The entry of new firms may cause the average costs of
all firms to rise
• prices of scarce inputs may rise
• new firms may impose “external” costs on existing firms
• new firms may increase the demand for tax-financed services

56
Long-Run Equilibrium: Increasing-Cost Industry
Long-Run Equilibrium: Increasing-Cost Industry
Long-Run Equilibrium: Increasing-Cost Industry
Long-Run Equilibrium: Increasing-Cost
Industry
Long-Run Equilibrium: Decreasing-Cost Industry
• The entry of new firms may cause the average costs of all
firms to fall
• new firms may attract a larger pool of trained labor
• entry of new firms may provide a “critical mass” of
industrialization
• permits the development of more efficient transportation and
communications networks

61
ASSIGNMENT (1)

ILLUSTRATE if average costs fall as firms enter, HOW the

long-run supply will be!
ASSIGNMENT (2)

63
Rules of Assignments
• This is individual tasks
• The assignment should be typed in the Microsoft Word
and converted to PDF.
• You should use Microsoft Equation for any notation or
equation you include.
• Indeed, you may easily copy your friend’s work, but
the one who works on it will be much worse off
because of you, so work your own!

64